"The Great Unwind Is Gathering Speed" - What Chris Whalen Is Worrying About For 2019

In this issue of The Institutional Risk Analyst, we ponder past prognostications and future risks in 2019. And we are happy to announce the publication of The IRA Bank Book for Q4 2018. For those of you who were furiously buying copies of the Q3 edition last week, for which we are most grateful, hit the download link again to get the Q4 edition. You’ll want to read about why US bank earnings growth is now 100% correlated to interest rates.

FYI, new editions of The IRA Bank Book are published about two weeks after the FDIC and other regulators release their institution level and aggregate data (roughly day 60 after the quarter end) for US banks. The popular IRA Top Ten Banks usually appears after quarterly earnings are complete. And yes, to your questions, we only sell the most recent edition of each report.

So what is our top concerns in 2019?

First comes liquidity. For the past several weeks, US equities have fallen as the great unwind gathers speed. The same pressures that are causing the Federal Open Market Committee to consider pausing on rate hikes in 2019 are forcing stocks lower.

Never mind the parade of mindless reasons for the stock market reset – trade, China or even a weak US economy – the key factor pushing markets lower is the radical tightening of credit by the FOMC. Even without a single rate hike in 2019, the tightening caused by the runoff of the Fed’s bond portfolio will continue to suck liquidity out of the financial system. And lowering the target rate for Fed funds really won’t help if markets lock up.

Just as quantitative easing expanded the US liquidity base, quantitative tightening or "QT" represents a structural decrease in liquidity. As the Fed’s balance sheet contracts, there is a dollar-for-dollar decrease in liquidity because the Treasury is running a deficit. A bank deposit becomes a Treasury bill on the national balance sheet, illustrating why the Fed and Treasury are two faces of the same agency. But the key point is that QT is beginning to impact markets and credit spreads.

The destruction of trillions in equity market valuation is creating a level of panic in the US markets not seen since 2016, when China fears caused the capital markets to seize up. We may be replaying that scenario again. With high yield spreads headed to the danger zone of 500bp over Treasury yields, that tells you that the policy message coming from Washington is off key. But it also means that the market for subprime debt, including leveraged loans and CLOs, is grinding to a halt. That sound you hear is Wall Street choking on conduits full of loans that cannot be sold.

Feldkamp’s First Law states that when spreads widen too much, debt markets stop functioning and equity markets lose value. We talked about this in “Financial Stability: Fraud, Confidence and the Wealth of Nations.” When the mix of policy and personalities is toxic, spreads blow out, debt markets freeze and wealth as measured by the equity markets falls. Sadly there are only a handful of people on the Street who get the joke. The majority is captive of a narrative where trade tensions are responsible for market weakness.

Next on the string of worry beads is Europe. The European Central Bank just announced the end of its version of “quantitative easing” or QE, but unlike the US the ECB intends to reinvest its bond portfolio indefinitely. There will be no “quantitative tightening” in Europe by actually allowing the portfolio to run off as in the case of the US Federal Reserve. We reported this to readers after our trip to Paris last March. This past week, ECB Governor Mario Draghi confirmed our belief that EU banks cannot withstand a significant increase in rates.

The list of banks in Europe that are effectively insolvent is long and growing, in part because the EU banking system is not particularly profitable. Again, as we noted in previous comments, strong banks are profitable banks. Profits allow you to build capital and deposits, and fund credit losses. For the banks of Europe and particularly nations like Italy, far too often there is little or no real profitability. This leads banks to hide credit losses and asset quality problems.

We were amused to read that Qatar is considering increasing its stake in Deutsche Bank, as the newspaper Handelsblatt reported Sunday. This brings back memories of a decade ago when Korea Development Bank was touted to be looking to acquire Lehman Brothers. Then as now, the reports are not particularly helpful. What DB needs is to be recapitalized or acquired, but so far no credible investors has been willing to put new capital into this troubled bank.

As we have discussed previously, the fact that insolvent Chinese aviation conglomerate HNA is selling its stake in DB means that the bank badly needs a new shareholder. And keep in mind that HNA was not a cash buyer of DB shares, but instead used leverage to fund its position. Presumably the Qataris have cash.

We see the failure or restructuring of DB as a very real possibility in 2019, an event of default that will force the larger issue of bank solvency in Europe. With the bank trading below one quarter of book value, the stock of DB is not suitable as an investment. When will the EU authorities accept the fact that DB is crippled and requires state aid in order to stabilize? In the event, the mirage of German economic power in Europe will evaporate.

Last comes China, both because of the growing potential for violent change and because western audiences are completely unprepared for this eventuality. Credulous western observers talk about the “long term” perspective of the Chinese Communist Party (CCP), but in fact this gang of “running dogs” to borrow the Maoist terminology is no different than western politicians. The make it up as they go. The CCP is no more able to manage a economy than is President Donald Trump.

The key difference in China is mountains of debt, no real equity leverage in the economy, and a payments system that is entirely focused through the Bank of China. But the most troubling development in our view are the growing signs that the CCP and paramount leader Xi Jinping feel compelled to take more and more authoritarian measures to retain political control.

The brutal rise of Xi Jinping to sole power in China is nothing if not a display of massive insecurity, starting with the elimination of all rivals and ending with the dissolution of collective leadership. Revelations that Beijing feels the need to imprison over a million Muslim Uighurs in work camps, a mere 10% of the 11 million population of Xinjiang, also suggests a very direct fear of instability.

Mao Tse-Tung wrote in World Marxist Review in 1961:

“A potential revolutionary situation exists in any country where the government consistently fails in its obligation to ensure a least a minimally decent standard of life for the great majority of its citizens. If there also exists even the nucleus of a revolutionary party able to supply doctrine and organization, only one ingredient is needed: the instrument for revolutionary action.”

The revolutionary party is radical Islam, spilling across China’s western and southern borders. The CCP well recognizes the parallels with Chinese history. And it has happened before. Just as the Chinese nationalists and communist forces defeated the Japanese in WWII after decades of brutal occupation of China by Tokyo's fascist rulers, the CCP is now in the position of the oppressor and the Islamist “terrorists” are the liberators. No member of the CCP who understands China’s history could fail to be impressed by this parallel.

Watching the liquidation of the HNA Group, a process which we now learn from Reuters is being administered by China Development Bank, you begin to appreciate just how fragile is Beijing’s control of the economy. CDB, of course, is HNA’s biggest creditor, and it in turn is an appendage of the Bank of China.

When Wang Jian, the co-chairman and a co-founder of HNA Group, “accidentally” fell off a wall in Provence, France, he was atoning for creating a scheme so gigantically absurd and so heavily leveraged that it threatened the CCP. The CCP is happy to tolerate or even encourage wealth creation, but only so long as it does not become a problem.

HNA’s $50 billion debt fueled shopping spree was and is still a problem for China in 2019, but only illustrates a larger issue of national economic solidity and cohesion. Westerners may need to consider the possibility of political change in China, a process that historically has come from the periphery and moved to the center in Beijing. Offshore investors who have become enamored of the illusion of political stability in China may want to recalibrate the reality gauge in 2019.